Eventually, of course, as revenue must always reach the level of expenses and these always rise, governments borrow more and more. It reaches a point at which they don’t have enough revenue to pay for even the interests of the bonds they sold, much less for the capital.

This is how, through the accumulation and piling up of interests, selling bonds to citizens and countries contributes to inflation. This process is not inflationary by itself, but it forces governments to borrow more and more. This means that the government needs to sell more and more bonds to their own banks, which in turn creates more and more money out of thin air. This is inflationary, and how!

When all starts to get flushed down the drain

There is also a side effect of all this borrowing and spending. As more money is created and spent, its price (the interest rate) drops. At the same time and as we have seen in the lesson Austrian Economics In Theory all this extra money creates booms and busts. Eventually, the economy goes down the drain permanently. Business do not invest no matter how cheap the price of money gets. Central banks keep creating and spending more money to a point at which interest rates get to zero. This is the infamous ZIRP policy (Zero Interest Rate Policy). At this point, there is no way to “stimulate” the economy simply because business are not borrowing and therefore they are not expanding. It is the famous “pushing on a string”. No matter how hard one pushes, the string simply gets more and more flaccid. There is no way to push anything. Central banks, of course, will keep creating more and more money simply because they don’t have any other tool to stimulate the economy. All they do is print, print, print and then print some more. All for nothing. The government spends, spends, spends and then spends some more, increasing its debt and with it, its need for more borrowing and spending.

When all is flushed down the drain

A country may stay at ZIRP for many years, decades even. Japan went into ZIRP in the 1980’s and it is still stuck in it. In reality, there is no way out… well almost none as we will see.

During ZIRP there are two issues preventing the economy from restarting. The first one are the businesses who do not want to borrow to invest because the economy is heavily depressed. The other one are the banks who do not want to loan because the chances they will lose their investment if they do is too high. And so, because central banks are creating more money out of thin air, this money eventually makes its way to other bank’s volts, where it sits and does nothing. These are the famous “excess reserves”. This is central bank jargon for they have too much money in the vaults and are not loaning.

During “normal” economic conditions, banks try to be fully invested. They want to squeeze out up to the very last cent. In order to do so, they must loan all the money they have leaving only the required “reserves” in their vaults. These reserves are about 10% of all their money. This number, 10% is more or less consistent throughout the world. In some countries this is legislated, in others controlled by the central banks and in others it is just a daily fact of banking. Therefore, when banks have more than 10% of their money sitting in vaults, anything over 10% is an “excess”.

Anyhow, by now central banks are desperate to get the economy going again. And so, enter voodoo economics. Voodoo economics are non-orthodox methods to “simulate” the economy. In other words, they make up this stuff up as they go along. Nobody really understands exactly how these “new and improved” economic measures are supposed to “stimulate” the economy, but the central banks try them anyways. The most famous one is “Quantitative Easing” or QE as it is known in the right “circles”.

QE is voodoo economics because it attempts to do what it is impossible. The idea is that investment is controlled by borrowing in the long term. Companies understand that the development and maturity of investments take time. Therefore, money must be borrowed long term. This means that private bonds must be issued to 5 or 10 years. But people are not stupid. They understand that lending to 5 or 10 years is essentially very risky. Economists can’t forecast what is going to happen tomorrow, much less to 5 or 10 years. Consequently, long term interest rates tend to be much higher than short term. In Austrian Economic parlance, it is an issue of time preference (we have also seen this in the lessons Austrian Economics In Theory) So, if there would be a way to lower long term interest rates, that may appeal businesses who may decide to borrow and therefore kick-start the economy.

Introducing QE. This is simply the purchasing of long term existing bonds by central banks. This pushes money into banks’ vaults and at the same time rises bond prices. As bond prices and the interest they demand are inversely related (the higher the price of a bond, the lower the interest it pays), long term interest rates in bonds drop.

There is only a tiny flaw in the plan: businesses won’t borrow.

Of course the whole concept of QE is idiotic! Their thinking goes like this. Banks are flushed with cash. They don’t lend and businesses don’t borrow. That’s OK. We will add more cash to banks and in so doing they will lend and business will borrow. Totally, completely and utterly idiotic.

The end result of QE is, essentially, nothing. With one exception. The amount of cash in banks’ vaults it’s very, very high indeed. And this poses a grave danger.

The manure hits the fan

Eventually, at some point, over many, many years, businesses begin to borrow. The choice for business is clear: they can either contract and go out of business or take loans and begin new projects and enterprises. This is a lesson that most businesses have learned in developing countries but not in developed countries. Eventually, timidly first, businesses begin to borrow. In so doing, banks begin to use their 1 to 10 multiplication power to create money out of thin air. As the economy begins to grow fueled by artificially low interest rates, businesses begin to borrow more and more. As they do, interest rates begin to climb because money becomes scarcer. Central banks refuse to act under the premise that doing anything may interfere with the nascent economic revival. And so they allow inflation to grow.

Their intention is, of course, to stop inflation when it reaches their target, this is usually about 2%. But… and there is always a but… the economy is always not “strong enough” so they let it continue. 3%... 4%...5%...6%... and going and going and going.

With every loan, more and more new money is created and enters the productive circle. More new money means more inflation. More inflation means higher interest rates… which add to the already growing interest rate.

In all this mess, we still have the government with its un-payable debt. They need to keep borrowing more and more just to keep up with the interest rate payments. However, now they have a problem. As interest rates are growing, if the central bank wants to sell new bonds, they must offer “competitive” interest rates. Nobody in their right mind will lend money to the government at 5% per year, if the inflation alone is 9%. So, the government ends up paying increasingly higher interest rates. Which increases its interest rate payments, which increases their borrowing which increases inflation. And so on and on.

Presto, we go from inflation, to high inflation to hyperinflation.

When something can’t continue, it won’t

In hyper inflationary economic conditions, it is pretty much impossible to conduct business. Just imagine this, you buy 1000 gadgets at 1 morlock each. You sell them at 1.20 morlocks. But, it takes you 6 months to sell them. During this time, inflation rose from 2% per month, to 10% per month. By the time you sold all your gadgets, you made 1200 morlocks, but new gadgets are being sold to you at 1.5 morlock each. You just lost 0.30 morlock per gadget!!!

In hyper inflationary conditions, it is impossible to conduct business or plan adequately for them. Although it is true that people survive and businesses survive, economic conditions only worsen.

At the same time, as the government reaches a point of non-payments, it defaults. This is, even borrowing to the maximum and printing day and night, the government cannot pay even the interests of the debt. The government becomes bankrupt.

Game over… well… we only wish it would be so.

When something can’t continue, deal again and start all over

Enter the IMF (International Monetary Fund) and the WB (World Bank). As many bonds that central banks sold were denominated in “hard” currencies (this is not in morlocks that can depreciate but in dollars or euros or swiss francs), hyperinflation cannot wipe them out. Only local suckers that bought bonds in morlocks receive their money back in worthless currency. International investors know better.

And so, the economic powers that be, pressure the EU, US, IMF, WB and a myriad of other alphabet soup quasi-governmental agencies, to give this “poor” country a break. And so, we now have endless economic “missions” to this country where “experts” pressure new, tough, economic “measures” on the country so that they can extend “bridge” loans and / or debt swap or a gamut of voodoo economic measures designed to save the lenders while squeezing the country for all is worth.

In the beginning, all this seems to work. Economic conditions deteriorate severely but inflation seems to decrease. The economy recovers a little. When this happens, governments begin to spend and borrow anew and the cycle begins again. This is boom and bust at the country level on an astronomic scale.

What happens next?

Nobody knows. History tells us that when countries default for real, without any last minute lifesavers, the debt is wiped out and eventually the country recovers. However, in this last modern era, with all these “new and improved” international banking organizations, this does not seem possible. The destructive cycle goes on and on.

It is our belief that this cycle will end only when these banking organizations run out of money. This will eventually happen because the US and the EU (their source of money) are bankrupt and China simply cannot afford these loans (nor it has any interest in so doing because its own interests are not being threatened).

It is our belief that at that time, the cycle will be broken and countries will begin their long way towards dissolution. This, we explained in our lesson When Countries Dissolve.

Conclusion

In the end, yes. Deficits lead to debt and debt leads to inflation. It is inevitable. However, it is not straightforward. What is going to happen and how much inflation is created, depends heavily on where in the cycle of boom and bust the economy is located.

And now you know. You can choose to ignore these fact or you can warn your fellow citizens. Eventually, they will thank you for it. But right now, it’s your choice. You decide the future.

Note: please see the Glossary if you are unfamiliar with certain words.